I'm a Fellow at the Adam Smith Institute in London, a writer here and there on this and that and strangely, one of the global experts on the metal scandium, one of the rare earths. An odd thing to be but someone does have to be such and in this flavour of our universe I am. I have written for The Times, Daily Telegraph, Express, Independent, City AM, Wall Street Journal, Philadelphia Inquirer and online for the ASI, IEA, Social Affairs Unit, Spectator, The Guardian, The Register and Techcentralstation. I've also ghosted pieces for several UK politicians in many of the UK papers, including the Daily Sport.

Nick Hanauer Doesn't Know His Galileo Let Alone His Economics

So Nick Hanauer, who made that try out video for TED on his interesting views about wealth creation, has been to Congress to tell them all about it. And sadly we find that he still doesn’t quite know what he’s talking about. A partial transcript is here.

I’d like to finish with a quick story. About 500 years ago, Copernicus and his pal Galileo came along and proved that the earth wasn’t the center of the solar system. A great achievement, but it didn’t go to well for them with the political leaders of the time. Remember that Galileo invented the telescope, so one could see, with one’s own eyes, the fact that he was right. You may recall, however, that the leaders of the time didn’t much care, because if earth wasn’t the center of the universe, then earth was diminished—and if earth was diminished, so were they. And that fact–their status and power–was the only fact they really cared about. So they told Galileo to stick his telescope where the sun didn’t shine and put him in jail for the rest of his life.

Well, no. Galileo didn’t invent the telescope, although he did improve it and manufacture a number of them. And the argument over heliocentrism wasn’t about the power of earthly rulers: rather about scripture. It’s an argument we’re still having with certain groups in fact: should we take all parts of the Bible to be literal truth or can and should we take some or more parts of them as allegory? Galileo was on the allegory side: as I would expect are most readers here. Although we all know that there are large numbers of people who insist that, just as one example, the story of the Creation in Genesis is to be taken as literal truth. And finally, Galileo wasn’t jailed for the rest of his life: he was sentenced to jail and then the next day this was commuted to house imprisonment.

Now you might think these are mere quibbles. But I’m using them as an illustration of the point that Mr. Hanauer isn’t quite wholly accurate on each and every detail that he puts forward in his arguments. This becomes important here:

The extraordinary differential between the 15-20% tax rate on capital gains, dividends, and carried interest for capitalists, and the 39% top marginal rate on work for ordinary Americans is just one of those privileges.

For of course the US doesn’t in fact have a full tax rate of 15% on dividends nor 20% on capital gains. What it has is those tax rates charged to the individual: but there’s another layer of tax that applies at the corporate level. By looking just at who writes the check Hanauer is entirely misleading as to the actual rate of taxation on those monies. The integrated tax rate on dividends is, for 2012, a shade over 50%:

The current top U.S. integrated dividend tax rate is 50.8 percent – fourth highest among OECD and BRIC countries

And the capital gains tax rate on stocks in incorporated companies is similarly high:

The current top U.S. integrated capital gains tax rate is 50.8 percent – fourth highest among OECD and BRIC countries

Now you might think that the Alliance for Savings and Investment might be a slightly biased source. So here’s a Swedish study making exactly the same point (pages 11 and 12 for the interesting table).

And no, I’m sorry, the argument that it’s not double taxation doesn’t work here. Yes, it’s true that there are layers of taxes and that when money moves from one person or organisation to another then taxes are often levied. But that table there, showing that the US has one of the highest integrated tax rates on dividends. is comparing like with like. It’s adding the corporate level and the individual level taxes for all of the countries being studied. Compared to other places the US simply does not have a low level of taxation on dividends: quite the contrary, it’s rather high.

And then we come to Hanauer’s real and most basic misunderstanding. He’s attacking entirely a straw man argument of his own making.

For 30 years, Americans on the right and left have accepted a particular explanation for the origins of Prosperity in capitalist economies. It is that rich business people like me are “Job Creators. ” That if taxes go up on us or our companies, we will create fewer jobs. And that the lower our taxes are, the more jobs we will create and the more general prosperity we’ ll have.

Many of you in this room are certain that these claims are true. But sometimes the ideas that we know to be true are dead wrong. For thousands of years people were certain, positive, that earth was at the center of the universe. It’s not, and anyone who doesn’t know that would have a very hard time doing astronomy.

My argument today is this: In the same way that it’s a fact that the sun, not earth is the center of the solar system, it’s also a fact that the middle class, not rich business people like me are the center of America’s economy.

No, our argument about tax rates is not about job creation: it’s about the creation of consumer surplus. Given the importance of this idea a small detour.

Consumer surplus is the value that I gain from something, over and above the price I’ve had to pay for it. Or perhaps the value that all consumers have gained over and above what all consumers have had to pay for it. As an example, one I’ve used before, imagine the two litres of water (including my coffee and tea etc) that I like to drink each day. I would happily pay $10 for each litre of this: I have done so occasionally in fact when in certain locations. The reason I’m willing to pay such a vast sum is that dirty water is highly likely to kill me as it kills tens of millions each year in other countries. But I also live in a country where I pay a modest sum each month (€20 actually, call it $30) for potable water delivered to me through the pipes. So, I would be willing to pay $600 for water a month: I actually pay $30 (I also get clean bathing and washing water for free but let’s not complicate such matters). My consumer surplus is therefore $570 a month.

Note that this number doesn’t appear anywhere in GDP (nor GNP, NNI or any of the other variants) but it is this consumer surplus that makes us all by any historical, or even current global, standard so enormously, vastly, rich. For there is such a consumer surplus (of differing levels to be sure) on absolutely everything we purchase. There must be, by definition in fact. For we only purchase those things that provide us with greater value than they cost. Hmm, perhaps we should qualify that to we only voluntarily purchase those things that are worth more to us than they cost us. There’s certainly a large number of people who think that we are forced to purchase too much government.

Who is it that provides us with this consumer surplus? In the end, it boils down to those entrepreneurs, the businessmen like Nick Hanauer. It is they that organise the companies into organisations that produce the things that are worth more to us than we must pay them. That produce that consumer surplus.

Now, if the entrepreneurs were getting the majority of the gains then we might indeed think that they should cough up more of those gains. But as it happens we know that we consumers get the majority of the gains in consumer surplus. Not just the majority in fact, the vast majority of the gains flow to us, the consumers. From William Nordhaus:

We conclude that only a miniscule fraction of the social returns from technological advances over the 1948-2001 period was captured by producers, indicating that most of the benefits of technological change are passed on to consumers rather than captured by producers.

What is “miniscule” in this context?

Using data from the U.S. nonfarm business section, I estimate that innovators are able to capture about 2.2 percent of the total social surplus from innovation.

That is, of the new wealth created by people starting new companies to do new things, 2% or so of the wealth goes to the people doing the creating and 98% of it goes to the consumers in the form of that consumer surplus.

At which point we’ve got to wonder why anyone is thinking of taxing these entrepreneurs at all. Forget about the money they make, the jobs they do or do not create, these are irrelevant next to that important figure. We make 50 times more out of their work than they do.

All of which brings us back to Mr. Hanaeur and his understanding of economics. Specifically, he claims that the US has low tax rates on dividends and capital gains: it doesn’t. Given the workings of the corporate tax code they are both high by international standards and higher than on earned income. More generally he claims that prosperity comes from job creation: he identifies that as the middle classes having enough demand to be able to purchase the items produced. And I’m afraid that this is simply nonsense. Prosperity comes from the consumer surplus: the value the consumer gains over and above the value that the consumer has to pay to get the item. And whether you want to consider my water consumption of Professor Nordhaus’ examination of the entire American economy, that consumer surplus is vastly huger than anything else in determining the level of prosperity we all enjoy.

Finally, even though we don’t have lower tax rates for such entrepreneurial activity, we almost certainly should. For you can only get rich by supplying people with something that they believe provides more value than they have to pay for it (absent getting the government to take the money for you that is). Which by definition means that the successful entrepreneur must have been growing that consumer surplus that all enjoy in order to get ahold of the pitiful fraction of the total wealth that she has created. At which point demanding a large chunk of it in taxation starts to look, well, churlish. If not downright counter-productive. For we’d rather like people to continually take up the difficult task of being entrepreneurs in order to keep feeding us with more of that consumer surplus.

The US simply does not have low tax rates for entrepreneurs. But it most certainly should have.

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